Baker & McKenzie’s Basile Fémelat questions protection levels from EU rating agency regulations

Basile Fémelat, associate at Baker and McKenzie Luxembourg argues that new law to regulate rating agencies has not fully addressed investors’ blind reliance on them, nor some outstanding structural conflicts.

Companies pay hundreds of thousands of euros for a rating of the securities they issue, but the bailout of AIG and collapse of Lehman Brothers in 2008 showed that credit rating agencies (CRAs) can get their assessments wildly wrong. Will the EU improve the situation through its newly voted CRA III regulation?

Remedying the failures of 2008-09

The shortcomings of credit rating agencies combined with blind reliance on ratings by investors played a big part in the global financial crisis of 2008-09. The EU has adopted new regulations in a bid to ensure it doesn’t happen again and to limit the systemic consequences (“cliff effect”) if it does.

Regulations 1060/2009 (CRA I) and 513/2011 (CRA II) have sought to address these issues through new obligations on agencies requiring disclosure of the methodologies, models and key assumptions of the entire rating process, and mitigation of potential conflicts of interests. Meanwhile, oversight of rating agencies has been transferred from individual EU members to the European Securities and Market Authority.

More involvement from investors

However, the progress provided by CRA I and CRA II still appears insufficient. Investors who have suffered from losses due to inaccurate ratings have insufficient rights of redress; there is a lack of structural independence because the rating agency is paid by the issuer of the security; and competition is limited in a market of which 90% shared by just three agencies.

Against this backdrop, the new CRA III regulation aims to encourage investors to be more critical regarding ratings and to be able to better understand, analyse and if necessarily challenge them. The new text affirms the European Union’s efforts to eliminating any reference to external ratings in EU law by 2020. It especially introduces new requirements regarding timing of publication for sovereign ratings and structured finance instruments (disclosure and double rating obligations) in order to reduce mass effects on the markets following changes in the ratings. It also addresses conflicts of interest concerning crossed investments in both CRAs and rated entities and the possibility for investors and issuers to claim damages to CRAs in case of gross negligence or intentional fraud.

Remaining challenges

Nevertheless, there is still criticism that the structural conflict of interest resulting from the ‘issuer-pays’ model has not been successfully addressed, nor strong concentration in the rating market dominated by the three biggest actors. Proposals designed to boost the number of rating agencies however have run into opposition. The rule consisting in imposing rotation between several CRAs has finally been limited to re-securitisation ratings. Furthermore, where issuers decide to use several agencies for the same issuance, they even are allowed not to comply with the obligation to choose at least one ‘small’ CRA (i.e. a CRA representing less than 10% of the total market share) on the sole condition to record such decision.

Adopted at first reading by the European Parliament on January 16th 2013, the Council is now expected to adopt a very close version (if not similar) of the regulation in the coming weeks. Both European institutions had indeed agreed a compromise text in late November 2012. The new rules will finally enter into force twenty days after having been published in the official journal.


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